Heartland International Value Fund 1Q17 Portfolio Manager Commentary

Executive Summary

  • Security selection was positive with names in several sectors helping the Fund outperform the Russell Global® ex-US Small Cap Index, returning 10.09% versus 8.98%.
  • Asia was a source of strength with holdings in Hong Kong, Japan, and South Korea among the top contributors.
  • We’ve trimmed on strength in Brazil but remain overweight to Emerging Markets.

First Quarter Market Discussion

A temporary pause in the impact of macro influences abroad, improving economic numbers in Europe and China, and attractive valuations provided broad strength for international equities. Lack of the unexpected in foreign markets was in contrast to the U.S., where investors appeared concerned about political turmoil, elevated multiples for equities, and uncertainty as to whether reality would live up to heightened growth expectations. 

The lack of clarity in the U.S. set a defensive tone and investors took a risk-off stance. As a result, the Yen strengthened but the effect was muted for Japanese exporters and industrials.

Emerging Markets were particularly strong as optimism about a softening dollar overcame concerns tied to softening oil prices. Buying was broad with the majority of sectors up for the period. Excluding Energy, economically sensitive sectors led the rally.

Attribution Analysis

Security selection was positive with names in Consumer Discretionary and Information Technology (IT) helping the portfolio outperform the Russell Global® ex-US Small Cap Index. The Fund’s holdings in Materials and Energy detracted.

On a regional basis, Asia was a source of strength, with holdings in Hong Kong, Japan, and South Korea among the top contributors. Brazil was also a strong performer for the Fund.

Heartland Advisors consumer discretionary sector iconImpressive acceleration. Consumer Discretionary was a key driver of relative strength and contained a top performer. ZhengTong Auto Services (1728 HK), a Chinese auto dealership with 97 outlets in 32 cities across the country, was up sharply as investors began to anticipate higher luxury car sales, which make up 70% of the company’s volume and account for 86% of revenue.

Originally we were attracted to the business for its improving bargaining power with auto manufacturers, sales growth tied to a growing middle class in China, and its financing unit, which gave ZhengTong a competitive advantage in attracting customers.

Following the significant appreciation in share price, we trimmed a large portion of our exposure based on valuations. While shares are still at a discount to its peers on a price-to-book basis, we believe much of the near-term good news may already be priced into the stock.

Heartland Advisors energy sector iconEnergy drain. Following several months of firming prices, oil fell based on investor concerns about excess reserves coming to market. Questions about whether an agreement among members of the Organization of the Petroleum Exporting Countries to cut production would be renewed also weighed on prices.

Our holdings in the space underperformed the market and included a key detractor. Canada-based Cardinal Energy Ltd. (CJ CN) was down due to the decline in crude prices. Despite the setback, we believe the company’s valuation, strong balance sheet, and high-quality energy assets make it a compelling long-term investment.

After the recent decline, Cardinal is trading at just 0.74x book value, and its dividend yield is more than 6%. Because its debt level is minimal, we believe the dividend will remain even if low oil prices persist for the intermediate term.

Decline rates for the company’s oil production are much lower than those of its competitors. As a result, we believe Cardinal should be able to maintain its output levels without taking on significant capital expenditures.

Heartland Advisors information technology sector iconSigning on the digital line. Our holdings in IT produced strong results, and the group continues to be a source of attractive opportunities. We initiated a position in Wacom Company Ltd. (6727 JP), a Japan-based technology company that makes digital stylus products for consumer tablets and solutions for high-end graphics used in the professional market. The company has recently launched several new professional products including one with the ability to support 3-D design. These offerings should drive replacement demand and lead to top-line growth. Despite the improving business cycle, the company continues to trade in line with its trough revenue of the past few quarters. Given that a sales cycle typically lasts up to four years, we believe shares are in the early stages of a recovery and that its valuation of just 2.4x price-to-book versus a five-year average high of 4.0x provides significant upside.

Portfolio Activity

We’ve taken strength in several of the Fund’s holdings as an opportunity to harvest gains and redeploy assets elsewhere. We’ve sold on strength in Brazil but remain overweight to Emerging Markets as a whole. The Fund’s names in Japan have also outperformed, and our recent trimming in the country has resulted in a modest underweight to the region. The move reflects our approach of mitigating risk and is not a sign we view Japan’s prospects negatively.

Companies in the UK remain attractive based on valuations, a weak currency, and modest expectations for the country’s economy. The Fund remains overweight to the area.

Outlook and Positioning

We expect recent calm in the global markets will give way to increased volatility in the months to come. Fallout from the Brexit vote will take on greater importance now that the UK has triggered Article 50 to begin the process of ending its membership in the European Union. China appears to be in the early stages of an economic uptick and its efforts to stabilize the Yuan could have spillover effects around the globe. Questions about the strength of European banks is an additional wildcard that may have a material effect on the economy as well as equities.

We cannot control macro factors but, as bottom-up investors, we can capitalize on opportunities that arise in response to external events. As the chart below shows, the performance gap between Emerging Market and domestic stocks is wider than it’s been in the past 20 years. Additionally, valuations for international stocks remain significantly more attractive than U.S. stocks. We view the discrepancy as an opportunity to own a portfolio of businesses trading at compelling valuations that is diverse by region, sector, and industry.

An Unsustainable Gap?

Heartland International Value Fund Portfolio Manager Commentary US vs Global Chart

Source: Bloomberg L.P. and Heartland Advisors, Inc., 7/31/1996 to 3/31/2017
Past performance does not guarantee futures results.

Japan remains attractive from a long-term perspective, but strength in economically sensitive areas has made bargain hunting more challenging. The UK continues to be fertile ground for investment ideas due to attractive valuations and more modest expectations compared to U.S. markets. We are also seeing opportunities in Emerging Markets such as Brazil. Inflation has moderated and interest rates are improving – both should provide a tailwind to well-run companies.

Our focus remains on finding sound businesses with strong management teams that have a history of prudent capital allocation decisions. We believe owning dividend paying companies with robust balance sheets provides downside protection while allowing for upside potential.

Thank you for the opportunity to manage your capital.

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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Michael Jolin

Michael Jolin

Jolin, CFA, is Vice President and Portfolio Manager for the Heartland International Value Fund. He has 14 years of industry experience, 8 at Heartland.

Heartland Advisors Value Investing Portfolio Manager Robert Sharpe

Robert C. Sharpe

Sharpe is Vice President and Portfolio Manager of the International Value Fund. He has 34 years of industry experience, 4 at Heartland.

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In the prospectus (pdf) dated 5/1/2017, the Total Annual Fund Operating Expenses After Fee Waiver and/or Expense Reimbursement for the investor and institutional classes of the International Value Fund are 1.25% and 0.99%, respectively. The Advisor has contractually agreed to waive its management fees and/or reimburse expenses of the Fund to ensure that Total Annual Fund Operating Expenses for the Fund do not exceed 1.25% of the Fund’s average net assets for the investor class shares and 0.99% for the institutional class shares, through at least 5/1/2019, and subject thereafter to annual reapproval of the agreement by the Board of Directors. Without such waiver and/or reimbursements, the total annual fund operating expenses would be 1.89% for the investor class shares and 1.63% for the institutional class shares.

Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. Performance information for institutional class shares of Funds that existed prior to their initial public offering is based on the performance of investor class shares. The investment return and principal value will fluctuate so that an investor's shares, when redeemed may be worth more or less than the original cost. All returns reflect reinvested dividends and capital gains distributions, but do not reflect the deduction of taxes that an investor would pay on distributions or redemptions. Subject to certain exceptions, shares of a Fund redeemed or exchanged within 10 days (90 days for the International Value Fund) of purchase are subject to a 2% redemption fee. Performance does not reflect this fee, which if deducted would reduce an individual's return.

An investor should consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information may be found in the prospectus (pdf). To obtain a print prospectus, call 800-432-7856. Please read the prospectus carefully before investing.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true.

Economic predictions are based on estimates and are subject to change.

Because of ongoing market volatility, performance may be subject to substantial short-term changes.

There is no guarantee that a particular investment strategy will be successful.

Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

Heartland’s investing glossary provides definitions for several terms used on this page.

The International Value Fund invests primarily in small foreign companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies. Foreign securities have additional risk, including but not limited to exchange rate changes, political and economic upheaval, and relatively low market liquidity. These risks are magnified in emerging markets.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

Dividend paying stocks cannot eliminate the risk of investment losses.

Foreign country classifications are generally determined by referencing country of domicile sourced from FactSet Research Systems Inc., however, Emerging Markets classifications may rely on country of risk designations.

As of 3/31/2017, ZhengTong Auto Services, Cardinal Energy Ltd., and Wacom Company Ltd. represented 1.08%, 1.29%, and 1.30% of the International Value Fund’s adjusted net assets, respectively. 

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

Sector and industry classifications as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems Inc. or the Global Industry Classification Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.

The above individuals are registered representatives of ALPS Distributors, Inc.

CFA® is a registered trademark owned by the CFA Institute.

Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®.

The Heartland Funds are distributed by ALPS Distributors, Inc.

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